Central bankers and their irrational fear

Mervyn King said

“Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.”

As an academic turned central banker, King knew of what he spoke. The fear is sometimes called fiscal dominance: that they will be forced to monetise government debt in such a way that means inflation rises out of control.

I believe this fear is a key factor behind central banks’ reluctance to think seriously about helicopter money. Creating money is no longer a taboo: with Quantitative Easing huge amounts of money have been created. But this money has bought financial assets, which can subsequently be sold to mop up the money that has been created. Under helicopter money the central bank creates money to give it away. If that money needs to be mopped up after a recession is over in order to control inflation, the central bank might run out of assets to do so. A good name for this is ‘policy insolvency’. [1]

There is a simple way to deal with this problem. [2] The government commits to always providing the central bank with the assets they need to control inflation. If, after some doses of helicopter money, the central bank needs and gets refinanced in this way, then helicopter money becomes like a form of bond financed fiscal stimulus, but where the bond finance is delayed. In my view that delay may be crucial in overcoming the deficit fetishism that has proved so politically successful over the last five years, as well as giving central banks a much more effective unconventional monetary instrument than QE. [3] But central banks do not want to go there, partly because they worry about the possibility of a government that would renege on that commitment.

The fear is irrational for two reasons. First, central banks already face the possibility that they may make sufficient losses on QE that they may require refinancing by the government. The Bank of England has requested and been given a commitment to cover those losses. There is no conceptual difference between this and underwriting a helicopter drop except probabilities.

The second reason is more basic. In today’s world, where in the major economies it is now well understood that interest rates need to rise in a boom to control inflation, it is hard to imagine a government that would make its central bank impotent by refusing to provide it with assets. If such a government ever existed, it would have long before ended central bank independence because it wanted to stop it increasing interest rates with the assets it already had. Under the government of central bank nightmares, the central bank would lose its independence before it could complain that the government was reneging on an earlier commitment to underwrite helicopter money.

The fear of fiscal dominance is itself not irrational, although it seems increasingly unlikely it would happen in a modern democracy. What is irrational is thinking that allowing helicopter money in a recession would make fiscal dominance more likely to happen. [4]

I have also argued that this irrational fear has already been costly. I have describedhow the widespread adoption of austerity at the beginning of the recovery represents the failure to politicians to follow basic macro. Here central banks become a policy intermediary between academia and politicians: they have the knowledge of how costly austerity can be when rates are zero. But what politicians heard from senior central bankers was not these costs, but encouragement to pursue austerity. An irrational fear of budget deficits may be one explanation for central banks being economical with the truth.

Central banks overcame one big psychological barrier when they undertook Quantitative Easing. That was the first, and perhaps the more important, stage in ending their primitive fear of fiscal dominance. They now need to complete the process, so we can start having rational discussions about alternatives to QE.

[1] A central bank cannot actually become insolvent, as this postexplains.

[2] No one to my knowledge has ever proposed giving the central bank the legal power to collect a poll tax.

[3] A key feature of deficit fetishism is a concern about deficits in the short term. Politicians seem happy to take measures that cut deficits in the short term even if debt becomes higher in the longer term. Indeed the analysis presentedby DeLong and Summers argues that hysteresis forces would not have to be that large before austerity would raise long run debt to GDP levels. We also know that deficit fetishism is specific to increases in debt caused by recessions: over the longer run if anything deficit bias implies rising rather than falling levels of government debt. So any form of fiscal stimulus that avoided an increase in debt in the short run but not in the long run would avoid deficit fetishism. That is what a money financed fiscal stimulus aka helicopter money aka People’s QE could do.

[4] Why am I confident that a government could not be so obsessed with its debt that it might renege on an underwriting pledge? It is because deficit fetishism is only politically attractive in a recession when individuals are themselves cutting back on their borrowing, and therefore feel the government should do the same. This will not apply when the recovery has taken place and inflation is in danger of exceeding its target.